Prospective real returns in fixed income

Discussion notes 2 -
18 March 2011

In this section, we discuss the potential long-term real return implications of current yield levels in developed economies’ government bond markets. Treasury yields in the major economies are at or very close to their historical lows. Forward-looking measures of real yields based on inflation-indexed bonds or on surveys of long-term inflation expectations are depressed.

From a strategic point of view, we must consider the longer-term implications of increased public indebtedness and unconventional monetary measures, such as quantitative easing, on our return expectations. Against this background, we conduct various decompositions of nominal yields into their real, inflation and risk premia components to assess the compensation that we can expect to receive for holding bonds over a five- to ten-year horizon.

Main findings

Forward-looking yield measures indicate that real hold-to-maturity returns on developed market government bonds could be very low compared to recent history and low relative to long-term averages.

Decompositions of current nominal bond yields into a real yield, inflation expectation and risk premia component suggest that risk compensation for holding bonds is thin.

Government debt dynamics and the high level of under-utilised resources in the developed economies could create an incentive for policymakers to attempt to keep real interest rates as low as possible to relieve the burden on the leveraged public and private sectors. This would reduce prospective returns.

A significant risk for bondholders in markets where real yields are kept artificially low is that other investors withdraw from those markets and a disorderly currency depreciation ensues during which real yields are driven significantly higher.